I’ve written over 1,000 articles, many of them on dividend growth investing.
And I don’t just talk the talk – over the last six years, I’ve routinely invested my personal savings in high-quality dividend growth stocks like those you’ll find on David Fish’s Dividend Champions, Contenders, and Challengers list.
In the process of doing that, I’ve achieved financial independence (at just 33 years old) on the back of the five-figure dividend income my six-figure portfolio generates for me.
So as you can imagine, you’ll find few bigger cheerleaders of this strategy than me.
[ad#Google Adsense 336×280-IA]Controlling personal expenses and investing excess capital into wonderful businesses that predictably pay and increase dividends is just an amazing strategy that can indeed allow one to achieve financial freedom.
However, as great as all of that is, it’s also important to be mindful of the price you pay for any dividend growth stock.
But how does one go about knowing whether or not a stock’s price is a good deal?
Is a stock that’s trading hands for $10 automatically “cheaper” than a stock trading hands for $20?
Absolutely not.
See, price is simply what you pay; value is what something is worth.
And it’s extremely important that you see the distinction there.
That goes for anything in life – you should know the difference between price and value for everything you go about buying throughout your life, be it appliances, shoes, or stocks.
A $10 stock could very well be more expensive than some other $100 stock.
But one first has to have an idea of what something is worth before deciding whether or not that thing is “expensive” or “cheap”.
Value gives context to price. Without knowing value, it’s not possible to know whether or not the price is reasonable and appropriate.
Fear not, though.
It’s actually not all that difficult to estimate the fair value of most dividend growth stocks out there.
In fact, there’s a system that’s been put together right here on the site.
And it’s freely available to all of you readers.
It’s one of fellow contributor Dave Van Knapp’s dividend growth stock investing lessons, but this system is specifically designed to help reasonably estimate the fair value of most dividend growth stocks.
Once you have a good idea of what a stock is worth, you can then decide what you want to pay.
Of course, the best price is one that’s as far below fair value as possible.
When you see a dividend growth stock selling for a big discount relative to its estimated fair value, you have an undervalued stock on your hands.
And undervalued dividend growth stocks are really appealing for a variety of reasons.
First, you’re likely going to see a higher yield.
All else equal, a stock’s yield will be higher when its price is lower. That’s because price and yield are inversely correlated.
That higher yield translates to more immediate income from your investment. And that should also mean more aggregate income over the life of the investment.
Second, your long-term potential total return is greater.
Yield is one major component to total return. If you’re boosting this component right off the bat, your long-term total return is more favorable.
But capital gain, the other component, is potentially boosted as well due to the gap between the (lower) price you paid and the (higher) value of the stock. That upside could be a major catalyst for greater long-term total return on top of the higher yield.
This means your long-term total return is potentially greater on both sides of the coin.
Third, your risk is lower.
Paying far less than what a stock is worth leads to what’s called a “margin of safety”.
That margin of safety is that aforementioned gap between price and value.
It lowers your risk in the sense that a whole lot of things would presumably have to go wrong before the value of the stock drops below what you paid.
But when dealing with high-quality businesses, things tend to go right far more often than they go wrong.
And, really, when you pay a price far below what a stock is worth, you don’t need a whole lot of good things to happen in order to see satisfactory investment results.
As such, the odds are simply on your side; the upside potential should be far greater than the downside risk over the long run.
With all of this in mind, you can probably see why I like to buy high-quality dividend growth stocks when they’re undervalued.
And it looks like there’s a stock on Mr. Fish’s CCC list that right now appears to be priced right…
Penske Automotive Group, Inc. (PAG) owns and operates car dealerships that sell new and used cars. These dealerships also provide parts, service, and collision support.
As of December 31, 2015, Penske Automotive Group operated 181 franchises in the U.S. and Puerto Rico, along with 174 overseas (primarily in the United Kingdom).
The dealership business model is attractive in the sense that a customer has to visit one if they’re interested in buying or leasing a new car.
And franchises have plenty of other opportunities to turn a profit.
Because of their OEM support and the way warranties work, a dealership’s service center is the preferred repair facility for any customer who purchases or leases a new car. So there’s the obvious opportunities for business there in terms of parts and labor.
And when a vehicle is involved in any type of collision, a dealership’s collision center offers a factory-approved center for parts and service to make the car whole again.
There’s also the opportunities for selling used cars, which tend to offer much higher margins than new cars. Because of the fact that customers tend to trade in older cars when purchasing new(er) cars, dealerships tend to have the “first look” at these cars. This allows the company to build up an inventory on the cheap.
Of course, there’s also the financing and insurance products available.
But the industry is extremely competitive, where price tends to be a primary differentiating factor.
Fortunately, Penske Automotive Group insulates itself somewhat by its geographic diversification and broad brand exposure (it sells more than 40 different brands of new cars).
Moreover, it focuses on import and luxury brands, which tend to attract wealthier clients. This means their sales should hold up relatively well during major economic downturns.
But as a dividend growth investor, a company’s ability and willingness to pay and increase a dividend is a primary concern.
So what do we have here?
Well, the company has increased its dividend for the past six consecutive years.
And the rate at which the company has increased its dividend recently is pretty astounding: the three year-dividend growth rate is 26.9%.
What’s fairly unique about this stock is that the dividend is usually increased quarterly. So that means your income is increasing that much more often than what you’ll usually see with most dividend growth stocks.
And with a payout ratio of just 29%, there’s still plenty of room for future dividend increases.
On top of all of that, the stock offers an appealing yield of 3.01% right now.
That yield is solidly above the broader market.
More importantly, that yield is more than 140 basis points higher than this stock’s five-year average yield of 1.6%.
So we see that benefit of a higher yield (relative to what otherwise would have been offered if the stock were fairly valued or worse) that was mentioned above playing out right here.
The dividend offers a lot to like across the board.
Quarterly increases, a rather high yield, really strong dividend growth, and a moderate payout ratio.
The one knock against the stock’s dividend, though, is the fact that the company eliminated its dividend during the financial crisis.
Although their results weren’t as bad as some of the other major domestic dealership networks, the company took a heavy loss in fiscal year 2008, prompting the elimination of its dividend.
The flip side of that coin is that the company has made up a lot of that ground. And the financial crisis is likely a generational event.
Let’s next take a look at the company’s top-line and bottom-line growth over the last decade, which will tell us what kind of growth trajectory this company demonstrates over the long run.
We’ll then compare that to a forecast for near-term growth.
This should help us immensely when it comes time to value the company and its stock.
Revenue is up from $11.242 billion to $19.285 billion from fiscal years 2006 to 2015. That’s a compound annual growth rate of 6.18%.
The company’s earnings per share improved from $1.32 to $3.63 over this period, which is a CAGR of 11.90%.
Now, both revenue and profit took a big hit during the Great Recession. But the company also bounced back quickly. And we can see the long-term growth rates here are really strong.
Steady improvements in profitability and efficiency helped propel some of that excess EPS growth.
Looking forward, S&P Capital IQ believes Penske Automotive Group will compound its EPS at an annual rate of 8% over the next three years, citing strong competition for what looks like modestly increasing new car volume.
What should come at no surprise, the company does maintain a leveraged balance sheet.
The long-term debt/equity ratio stands at 0.70, while the interest coverage ratio is just a bit over 5.
It’s not cheap to build out and maintain a large network of dealerships, especially those that cater to affluent clients that have high expectations for quality and service.
That said, Penske Automotive Group’s balance sheet is in line for its industry.
Profitability, however, does lag some major competitors. Though the company’s profitability has improved markedly over the last decade, it caters to clients that can purchase cars in cash, meaning opportunities in financing and insurance aren’t as strong as competitors that sell cheaper cars.
Over the last five years, the firm has averaged net margin of 1.64% and return on equity of 17.19%.
This is a really interesting business.
You’ve got a captive audience on one hand and strong competition on the other.
But the bigger picture seems to indicate that this company is operating at a high level in absolute terms and certainly in relative terms.
Meanwhile, there are huge barriers to entry here. One can’t encroach on a dealership with franchise agreements in place. And it’s quite costly to build out a network that can offer the kind of scale that a dealership needs to remain in business through the cycles.
Warren Buffett certainly likes the business model, with him buying the nation’s largest privately-owned auto dealership back in 2014 for Berkshire Hathaway Inc. (BRK.B).
The only major issue that could present itself over the long run is if the dealership model somehow becomes obsolete – Tesla Motors Inc. (TSLA) is successfully selling directly to customers.
And self-driving cars (which are coming) could present a more homogeneous experience, meaning some luxury brands may not be as appealing/prevalent. Less accidents also means less collision work.
As such, we want a good deal on these shares (which is always the case).
Fortunately, the stock seems to be quite cheap.
The P/E ratio is sitting at 9.63 right now, which is obscenely cheap for a company growing in the double digits. For perspective, that’s about half the broader market. Compared to the five-year average P/E ratio of 14.4 for the stock, you can see a clear discount. Of course, the yield is also significantly higher than its own recent historical average.
That does seem cheap for the quality and growth of the business. But how cheap is it? What’s a reasonable estimate of its fair value?
I valued shares using a dividend discount model analysis with a 10% discount rate and a 7% long-term dividend growth rate. I think this growth rate is very conservative considering the payout ratio, recent dividend growth, and forecast for EPS growth over the foreseeable future. But I’m also factoring in the competition and the dividend elimination a few years ago. The DDM analysis gives me a fair value of $38.52.
The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide. The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.
It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today. I find it to be a fairly accurate way to value dividend growth stocks.
I believe we’re looking at a stock that’s ordinarily cheap but especially cheap right now. However, my viewpoint isn’t the only one out there. And I’m not the only one who thinks the stock is cheap…
Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system. 1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.
Morningstar rates PAG as a 4-star stock, with a fair value estimate of $42.00.
S&P Capital IQ is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line. They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.
S&P Capital IQ rates PAG as a 4-star “buy”, with a fair value calculation of $48.80.
Looks like my estimate is very much on the conservative side. But I like to average out these three valuation opinions so as to distill these varying viewpoints and methodologies down into one valuation figure, which should increase the accuracy. That final valuation is $43.11, which indicates the stock is potentially 20% undervalued right now.
Bottom line: Penske Automotive Group, Inc. (PAG) is a high-quality and diversified business. Recent dividend growth has been nothing short of astounding, and I think there’s a lot more to come. With the possibility of 20% upside on top of a yield that’s substantially higher than its recent historical average, this appears to be an incredible opportunity here.
— Jason Fieber
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